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Would I be bonkers to buy shares in Tesco right now?

Something fundamental has changed about Tesco (LSE: TSCO) over the past few years.

There was a time when many investors considered the supermarket sector to be defensive and cash-generating. Ideal for supporting a stream of dependable dividends.

But if Tesco was ever a sleep-well-at-night investment, it caused shareholders to fall out of bed with a bump around six years ago when it suffered a profit, dividend and share-price collapse.

Old assumptions out the window

Out the window went all those previous assumptions about Tesco and the supermarket sector in general. Instead of being safe and reliable, Tesco revealed its true colours as a low-margin outfit operating in a sector characterised by cutthroat competition. The Tesco empire had been built on sand and it didn’t take much to make it wobble, just a nudge or two from disrupting competitors Aldi, Lidl and others in the UK.

The firm didn’t generally fare well abroad either and has been unwinding its overseas operations. Indeed, customers can be fussy, and they have plenty of choices. If Tesco doesn’t give people what they want, they vote with their feet and shop elsewhere. The business model strikes a fine balance, I reckon, and it doesn’t take much to upset things.

However, under chief executive Dave Lewis, the firm has been turning itself around. For a while, those numbers for growth in earnings looked impressive at 29%, 42%, 45% and 38%, for example. But the revenue figure is more or less back to where it was in 2014, and I reckon a firm can only go so far when it comes to squeezing efficiencies and profits out of an enterprise. Indeed, the forward-looking growth figures for earnings are less impressive at 6%, and 10%. I’m not expecting a return to double-figure advances any time soon, or ever.

A new problem

Now there’s a new problem with Tesco, as I see it. The valuation is far too rich. The recent share price close to 235p throws up a forward-looking price-to-earnings (P/E) ratio for the trading year to February 2021 of just under 13 and the anticipated dividend yield is just below four. My view is that the firm’s business is in long-term decline, so I’d want a yield of at least 5% to compensate me for holding the shares in the face of the many risks ahead.

But Tesco also fails a basic test I like to apply: is the share capable of outperforming its index, in this case, the FTSE 100? My view is that Tesco seems unlikely to soar ahead of its index in the years ahead but it still has exposure to all the downside risks of its sector. So in this case, I’d rather invest in a FTSE 100 index tracker fund than take on the individual-company risk of holding Tesco shares.

To me, there are better strategies than buying the shares of firms that have recently demonstrated their ability to fail in some way. So I reckon I’d be bonkers to buy Tesco shares right now.

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Kevin Godbold has no position in any share mentioned. The Motley Fool UK has recommended Tesco. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.